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Archive for May, 2010

One expectation that exists with a macro-strategy fund is that as material economic, political, and social forces drive the investment strategy, it is more like conning an oil tanker than a destroyer. For the captain of an oil tanker, setting the course should be fairly straightforward, being derived from an analysis of the various routes available to get from point A to point B, taking into consideration major ocean currents, weather conditions, and any relevant particulars (e.g., avoiding shallows, pirate infestations, and difficult waters)—always keeping safety paramount. Thus one would expect relatively few changes in course, and those that are made should generally be anticipated well in advance.

This contrasts with the captain of a destroyer, whose mission may require him to expose his warship to danger, and whose course is highly likely to vary greatly from one moment to the next depending on the tactical situation (e.g., tracking or engaging a hostile sub that is undertaking evasive maneuvers).

However, when icebergs suddenly appear where they normally don’t, then all bets are off for the oil tanker, and while it may not be designed for bobbing and weaving, if that is what is required to optimally protect the cargo, that is what the captain has to do.

Folks, we are in iceberg territory. The market’s perception of reality vîs a vîs the European sovereign debt crisis—which morphing into a liquidity crises akin to 2008-09—is coming into closer congruence with our own analysis faster than we had heretofore anticipated, and as a consequence, we are reinstating our index short positions.

While we never anticipated that the “solution” of the Eurozone politicos—fighting too much bad debt with more debt—would be a viable solution, we are surprized the market so readily agrees with us. Default disguised as “restructuring” remains the only viable alternative for Greece (at least). The powers-that-be have avoided it for the same reason that the Fed and US government bailed out AIG, Citibank, Freddie, Fannie and their ilk—too many lenders to Greece are at risk. Unfortunately (although not surprizingly), delaying the inevitable has not, as was hoped, gotten us to a more convenient time for taking the medicine.

It will be interesting to see what happens but to improve our chances of enjoying the view, we need to move back to the “short” section of the stadium.

We are going with the Proshares Short QQQ (PSQ) ETF, whose managers “seeks daily investment results, before fees and expenses, that correspond to the inverse (opposite) of the daily performance of the NASDAQ-100 Index,” their Short DOW 30 (DOG) ETF, aimed at achieving “daily investment results, before fees and expenses, that correspond to the inverse (opposite) of the daily performance of the Dow Jones Industrial Average Index,” and their Short S&P 500 (SH) ETF, which seeks daily investment results, before fees and expenses, that correspond to the inverse (opposite) of the daily performance of the S&P500® Index.”

OK, OK…selling these positions back in February was a mistake. Since 10 February, GLD is up 10% and SLV is up 17%. (And they were up as much as 16% and 30%, respectively.)

We had two concerns about holding the precious metals (PMs) in February. The first was that the ascent of Paul Volcker to prominence in the Obama administration signaled a likely move towards austerity in advance of the Congressional elections, which would be deflationary and strengthen the dollar relative to the PMs (and other commodities). The second was that increased systemic risk stemming from the PIIGS sovereign debt issues would engender a flight to safety whereby US treasuries and the dollar would benefit to the detriment of all other asset classes, including PMs.

Well we weren’t smoking anything potent in February—or if we were, it was so potent that we have blacked out the memory—but imagining the Obama administration would embrace austerity probably is a better indication of fiction-writing ability than macro analysis. It may be that government policy—under both Bush and Obama—in response to our structural debt problems has been to fight fire with gasoline, with easy money and easy credit to encourage more private debt and policy changes such as the health insurance reform legislation that creates additional government obligations. We still think the electorate might be in a mood come November to throw out the rascals who are kicking the can down the road and using smoke and mirrors to try to keep the broken system from collapsing, but the government has made their deal with the establishment devil and evidently the “fix” is in.

Our reading on the flight to safety was better, in that U.S. treasuries have increased in value, the dollar has gotten stronger, and commodities from oil to palladium to basic materials have come down in price…but, unlike 2008-09, not the PMs. So we are taking advantage of this current minor retrace to reestablish our positions there, for all the reasons we cited back in 2007 in our original recs for gold and silver.

We expect that there is a lot more “down” coming, but we are stepping aside here in anticipation of a continuation of the suckers’ rally that has been ongoing since March 2009. And we remain cautious in our use of the reverse gear by virtue of our error in staying short during the rally in November-December 2008, which cost us a 29% haircut.

So despite a USA “recovery” with no job growth, foreclosure-challenged house prices, ever-deepening government debt and failures to deal with structural issues (social security et al) and systemic risk (neutered financial regulatory reform)…despite the evident spread of systemic-risk level problems to the Eurozone with their failure to address the underlying structural issues affecting the PIIGS…despite the risk of a significant slowdown in China where the government is trying to cool real estate speculation and inflation…we are cashing in our short chips here to ride out a potential bull-market storm.

This market is too volatile to ignore sentiment which can drive two-or-three year’s worth of “normal” movement into just a few weeks…even if such a move is in the “wrong” direction. These short positions bought us insurance against a major meltdown for the past couple of weeks, which risk appears to have lessened for the time being, and we exit them with a modest profit.

As those who were with us when we launched this portfolio back at the end of 2006 may recall, Malaysia is one of our favorite places to invest outside of the USA, and the iShares MSCI Malaysia Index ETF was one of our original 11 positions. We are looking forward to getting back here, hopefully soon. But for now, with systemic risk at an elevated level thanks to the Euro Zone’s uneven response to the PIIGS sovereign debt crises, we are stepping aside—at a profit that beats the market—to raise cash and reduce risk.

Our game publishing company, Activision Blizzard (ATVI), announced 1Q10 results yesterday that materially exceeded management’s guidance from three months ago. The guidance had called for revenues of $1.1 billion and a profit of twenty cents per share in the quarter and the actual results included revenues of $1.3 billion and a profit of 30 cents per share. The good news was tempered, however, by the realization that the bounty was largely attributable to the early release of a “Modern Warfare 2” expansion kit that had not been expected until the second quarter…and ergo the boost from which shall now be missing in 2Q10. And the beat was not a surprize, as management had preannounced it last month.

CEO Bobby Kotick stated, “Our better-than-expected first quarter performance was driven by strong global consumer demand for Activision’s ‘Call of Duty’ and Blizzard Entertainment’s ‘World of Warcraft’. Activision’s ‘Call of Duty: Modern Warfare 2’ was the #1 title overall in the U.S. and Europe for the quarter, which illustrates the continued momentum of our catalogue. Additionally, during the quarter, Activision launched DreamWorks’ ‘How To Train Your Dragon’ and the ’Call of Duty: Modern Warfare 2 Stimulus Package,’ which shattered Xbox LIVE records with more than one million packages downloaded in the first 24 hours…. We expect to deliver record calendar year non-GAAP net earnings and expanded non-GAAP operating margins. In addition, we continue to strengthen our franchise portfolio and development resources for the future. Our high-quality brands, industry leading operational capabilities and solid balance sheet should enable us to take full advantage of the opportunities afforded by the expanding interactive entertainment market and allow us to deliver continued superior returns to our shareholders. As of March 31, 2010, we have delivered compound shareholder returns of 28% compared to the S&P average of -2 % over a ten-year period. We continue to find ways to add profitable franchises that allow us to increase our operating margins. In this regard we recently announced a ten-year alliance with Bungie, one of the premier studios in our industry. This relationship will allow Activision to broaden its product portfolio with exciting new games and underscores our commitment to partnering with the best creative talent in the industry.”

Management also announced that as of 31 March the company had purchased $92 million—approximately 8.5 million shares—of common stock at an average price of $10.84 per share under the $1 billion stock purchase program announced in February. Guidance for 2010 still calls for revenues of $4.2 billion including $925 million in 2Q10 and 49¢/share of earnings (up from the previously projected 47¢) including 11¢ in 2Q10.

First quarter highlights included:

In the quarter, “Call of Duty: Modern Warfare 2” became the #1 best-selling third-party video game of all time

For the quarter, “Call of Duty” was the #1 third-party franchise in the USA and Europe

For the quarter, “Band Hero” and “Cabela’s Big Game Hunter 2010” were top-10 titles on the Nintendo Wii in the USA

For the quarter, “Call of Duty: Modern Warfare 2” and “World of Warcraft: Wrath of the Lich King” were top-10 PC titles in the USA

10 February—stock repurchase program announced under which the company can repurchase up to $1 billion of ATVI shares

2 March—Activision Publishing announced the firing of Infinity Ward co-founders Jason West and Vince Zampella and the formation of a new business unit dedicated to the “Call of Duty” franchise headed by Philip Earl with the missions of expanding the brand to new geographies and devising “new margin expanding digital business models.”

In China, the good news finally panned out as on 12 February, Blizzard licensee Netease received permission from the General Administration of Press and Publications (GAPP) to (re)release The Burning Crusade, the first expansion released for World of Warcraft (WoW) back in January 2007. This ends seven months of uncertainty and intermittent interruptions in WoW availability on the mainland, ever since the expiration of Blizzard’s five-year deal with The9, their previous licensee. Still no word on the oft-delayed Wrath of the Lich King expansion, which Chinese WoW players have been awaiting—excepting those who have “defected” to Taiwan-based servers—for 18 months now.

Now that the China WoW contretemps winding down, we will have to content ourselves with the Infinity Ward legal warfare drama. That heated up late last month as 38 additional Infinity Ward employees sued Activision over alleged delinquent royalties. They are seeking between $75 and $125 million plus $500 million in punitive damages. This is in addition to the $36 million in royalties sought by fired Infinity Ward co-founders West and Zampella in their suit filed in March. It is unclear how many of the 38 employees involved in the second suit have left Activision, but clearly there are some morale issues in the “Call of Duty” business unit, to say the least.

In 2Q10, four games are expected to be released: the new racing title “Blur,” “Shrek Forever After” based on DreamWorks Animation’s upcoming feature film, an original Transformers game, “Transformers: War For Cybertron,” and “Singularity.” Also, in the last ten days the company announced release dates for “Starcraft II” (27 July and separately, as of 28 April the Mac beta was released and Intelledgement staff are expecting to install it imminently) and “Call of Duty: Black Ops” (30 November).

We believe that the optimism the market has reflected in the 80% surge in the S&P 500 index between 9 March 2009 and 23 April 2010 has been way overdone. While massive government intervention averted the collapse of many large financial institutions and huge stimulus programs have slowed the decline in residential real estate to a crawl and enticed the consumer to increase spending (at the expense of reducing the USA national savings rate from 5% to 3%), the so-called recovery has not produced any jobs or increase in income. What will happen when the surge of government stimulus dissipates? Meanwhile, private debt levels are still problematic and the commercial real estate situation continues to worsen.

Furthermore, US government policy continues to favor propping up the zombie banks and keeping the easy credit spigots open, and has exacerbated the strategic problem by not only failing to address the long-term structural problem of unsustainable entitlement obligations but has actually dug us deeper into the hole by focusing on so-called health insurance reform. In effect, our solution to the public and private addiction to profligate indebtedness thus far has been to vastly increase our indebtedness! While these policies have been successful in staving off “systemic risk” defaults, they will only postpone the day of reckoning.

But that is not why we are going short today in particular. We actually had been persuaded that the illusion of recovery had been so artfully contrived that the cracks in the foundation would remain hard to discern at least thru the 2010 elections. Unfortunately for the goldman behind the curtain, PIIGS happen. (That is, Portugual-Italy-Ireland-Greece-Spain, all with more or less severe sovereign debt issues.) The Eurozone political class have proven considerably less adept at implementing their own bailout in the case of Greece than USA policy makers were in 2008-09 with Fannie, Freddie, AIG, Merrill Lynch, Wachovia, Citibank, Bear Stearns, et al. As a consequence, systemic risk is up, and we are moving to protect capital here.

We are going with the Proshares Short QQQ (PSQ) ETF, whose managers “seeks daily investment results, before fees and expenses, that correspond to the inverse (opposite) of the daily performance of the NASDAQ-100 Index,” their Short DOW 30 (DOG) ETF, aimed at achieving “daily investment results, before fees and expenses, that correspond to the inverse (opposite) of the daily performance of the Dow Jones Industrial Average Index,” and their Short S&P 500 (SH) ETF, which seeks daily investment results, before fees and expenses, that correspond to the inverse (opposite) of the daily performance of the S&P500® Index.”

We don’t much care for the concept of establishing a permanent mechanism to coddle “too-big-to-fail” companies, either. Management of these enterprises should not be operating with the presumption that they will be bailed out if they screw things up. Can you say “moral hazard”? In a world of transparent markets, stringent capital requirements, and firmly enforced rules against chicanery, it ought to be rare for management to run large enterprises into the ground…but when and if they do, let them fail! That is the way capitalism is supposed to work: if you succeed, you are rewarded; if you fail, smarter, more adaptable competitors will take advantage of the opportunity to win your former customers by serving their needs better. Propping up the failures is bad for everyone: bad for the customers who continue to get suboptimal service, bad for the competitors who are not rewarded for working harder and smarter, and bad for the failing organization’s personnel, who instead of moving on to something they can better succeed at are in effect bribed by government largess to persist to fail at something they are bad at.

Well, the cardinal mechanism for bailing out the “too-big-to-fail” institutions has been secret sweetheart deal loans of American citizen’s tax dollars via the Fed. It was taxpayer money loaned to AIG, for example, that enabled Goldman Sachs to collect 100 cents on the dollar to redeem the credit default swaps they had purchased from the insurer as a hedge against declines in the value of mortgage-backed securities, while other less well-politically-connected enterprises were getting 20 cents on the dollar for similar instruments from similarly compromised CDS sellers.

So, if you agree that adding to the public debt level of Americans (and their progeny) to make good the losses of Wall Street banks is a bad idea, you might consider so informing your Senator, which thanks to Alan Grayson, you can conveniently do here. And here is the letter that Richard Burr and Kay Hagan received from us:

I’m writing to urge you to cosponsor and vote for the Federal Reserve Transparency Amendment. This amendment will allow the American people to know to whom the Fed loaned trillions of dollars of our money. I am very concerned that the Fed is, in effect, obligating me and my children to cover the debts run up by irresponsible, antisocial Wall Street fat cats and foolhardy foreign bankers (and some credulous domestic bankers, too)! I don’t believe the American people would stand for bailing out these fools if the extent of what’s happening is made public. But if this amendment does not pass, the Fed can continue to make sweetheart loans to whomever it wants, without telling Congress or the American people.

There are a number of problems with the existing bill:

1) It does not allow audits of the mortgage backed security purchase program, a $1.25 trillion program that at this point comprises the bulk of the Fed’s balance sheet. This program includes Freddie and Fannie backed debt.

2) It does not allow audits of possible losses on foreign currency swap lines, of which there were more than $500 billion at the height of the crisis. This includes unlimited credit lines granted to central banks all over the world, solely through at the discretion of Federal Reserve and without the input of any elected official or the State Department.

3) It does not allow audits of open market operations, where there is ample room for errors, market manipulation, and insider trading violations.

4) It does not allow audits of possible losses on securities acquired through non-section 13(3) facilities. This includes looking for possible losses, seigniorage, political conflicts and costs to the Treasury.

In the existing bill, all audits must remain redacted. The GAO can’t even tell Congress to whom the Fed is lending money, the amounts it is lending, or any details about collateral or assets held in connection with any credit facility. The GAO can never release a full version of any audit unless the Federal Reserve first chooses to shut down the audited credit facility.

The Federal Reserve Transparency Amendment that I am urging you to support does the following:

1) Requires the non-partisan Government Accountability Office (GAO) to conduct an independent and comprehensive audit of the Federal Reserve within one year after the date of enactment of the financial reform bill;

2) Requires the GAO to submit a report to Congress detailing its findings and conclusion of their independent audit of the Fed within 3 months; and

3) Requires the Federal Reserve within one month after the date of enactment to disclose the names of the financial institutions and foreign central banks that received financial assistance from the Fed since the start of the recession, how much they received, and the exact terms of this taxpayer assistance.

4) Does not interfere with or dictate the monetary policies or decisions of the Federal Reserve.

As you know, the House passed a similar amendment to HR 3996. Now is your chance to act, and to make a positive difference in our lives and the lives of future Americans. I urge you to cosponsor and vote for the Federal Reserve Transparency Amendment.